Why did the EU order Apple to pay $14.5 billion in taxes?

Earlier this week, the European Commission ordered Apple to pay an additional $14.5 billion in back taxes (13 billion Euros). The order, which both Apple and Ireland are contesting, is due to a finding that Ireland granted undue benefits to Apple, essentially treating the company as a preferred client rather than a neutral business.

According to the EC, Apple engaged in a bit of financial skullduggery. Instead of recording the profits generated by its EU businesses directly to those business segments (Apple Sales International and Apple Operations Europe), Apple attributed them to a “head office” that existed only on paper and did nothing to generate the revenues assigned to it. As a result of this arrangement, Apple’s tax declined from the criminally high rate of 1% in 2003 down to 0.005% in 2014 based on the profits of Apple Sales International.

It’s an arrangement that brings to mind the worst of Hollywood accounting. Hollywood accounting refers to the vast number of ways Hollywood can take a huge hit movie yet claim it made no money. According to New Line Studios, The Lord of the Rings trilogy, which collectively earned more than $2.9 billion dollars, actually suffered “horrendous losses.”

The two tax rulings issued by Ireland concerned the internal allocation of these profits within Apple Sales International (rather than the wider set-up of Apple’s sales operations in Europe). Specifically, they endorsed a split of the profits for tax purposes in Ireland: Under the agreed method, most profits were internally allocated away from Ireland to a “head office” within Apple Sales International. This “head office” was not based in any country and did not have any employees or own premises. Its activities consisted solely of occasional board meetings. Only a fraction of the profits of Apple Sales International were allocated to its Irish branch and subject to tax in Ireland. The remaining vast majority of profits were allocated to the “head office”, where they remained untaxed.

Therefore, only a small percentage of Apple Sales International’s profits were taxed in Ireland, and the rest was taxed nowhere. In 2011, for example (according to figures released at US Senate public hearings), Apple Sales International recorded profits of US$ 22 billion (c.a. €16 billion[1]) but under the terms of the tax ruling only around €50 million were considered taxable in Ireland, leaving €15.95 billion of profits untaxed. As a result, Apple Sales International paid less than €10 million of corporate tax in Ireland in 2011 – an effective tax rate of about 0.05% on its overall annual profits.

In subsequent years, Apple Sales International’s recorded profits continued to increase but the profits considered taxable in Ireland under the terms of the tax ruling did not. Thus this effective tax rate decreased further to only 0.005% in 2014.

What’s at issue here is the minimal tax rate paid by multi-national corporations and the way various companies often dodge their tax burdens. While this is not illegal in and of itself, such moves have become controversial in both the United States and Europe, though the US criticized the EC’s findings of fact and intent to require Apple to pay up. Ireland’s defense of its own arrangement also makes sense — low corporate taxes are a hallmark of Ireland’s appeal to businesses; Bloomberg reports that more than 700 companies have headquarters there. That’s part of why Ireland opposes the Apple finding — EU law forbids the granting of special tax breaks, and the Irish government doesn’t want to face the possibility of losing its preferred status as an overseas destination. Plenty of companies use similar tricks to avoid paying tax and if the EU starts investigating there could be significant fallout.